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Pension plans: Why all the fuss?

Def ined Benef it versus Def ined Cont ribut ion Pension Plans
A version of this commentary appeared in the Globe and Mail, Winnipeg Free Press and Montral Gazette Even an actuary like me knows that starting a discussion about pension plans at a social gathering is a conversation ender. And yet, recently two of Canadas largest unions (Air Canada and Canada Post) were on strike to save their Def ined Benef it pension plans against the wishes of the employer to switch new employees to Def ined Contribution plans. What are these plans all about and why all the f uss? As the name implies, a Def ined Benef it pension plan promises to pay you a Def ined Benef it when you retire. T his can be a f lat benef it plan (e.g., you get a pension that pays you $1000 a year in retirement f or every year of employment if you have 30 years of service you get $30,000 a year). Or it can pay out a percentage of your salary just prior to retirement (e.g., you get a pension that pays you 1.5% of your f inal average pay f or every year of employment if you have 30 years of service, you get 45% of your f inal average pay). So, in a Def ined Benef it plan, you know what annual benef it you will receive in retirement and, thus, you have a very good idea of how much more you need to save on your own to be f ully secure. T he f unding risks of a Def ined Benef it plan are carried by the employer (although in the long term, higher pension costs could f orce wages down). And the present environment packs a triple whammy of bad news f or these employers. First, interest rates are very low. So the value today of retirement income to be paid many years in the f uture is not as signif icantly discounted (e.g., at 4% versus 8%). Second, because of the f inancial crisis of 2008/09 and the mediocre recovery, pension plan assets are worth less than they were expected to be and pension plans are in the hole i.e., they owe more money to their employees than they have in the plan, (Air Canada has a $2.1B def icit and $3.2B f or Canada Post). T hird, people are living longer and this means they collect pensions longer and company costs go up. Adding to the concerns is the ratio of retirees to active workers that is now about 1 to 1 in both Air Canada and Canada Post. T his matters because the cash f low needed to pay benef its must come f rom worker contributions and investment returns. With the growing ratio of retirees to workers, the plan becomes more dependent on investment returns that are low today. In these Def ined Benef it plans, the worker has a def ined benef it and increased costs are the responsibility of the employer. T his is bad news today. Of course, if the economy improves and investment rates are up, good times f or the employer could return. T he opposite is true f or Def ined Contribution plans. Again, as the name implies, in a Def ined Contribution pension plan, it is the contribution that is def ined with no commitment to how much will be paid out in retirement. For example, the plan may provide that the employer will contribute $1 to the pension plan per hour of work. Or it could state that the employer will contribute 5% of an individuals pay into the plan. However, once the employer makes the contribution that is the end of the employers responsibility. If the stock market crashes or interest rates on investments are low, the worker will have a lower asset pool at

stock market crashes or interest rates on investments are low, the worker will have a lower asset pool at retirement and, thus, lower income post retirement. T hus, the worker has no idea until very close to retirement what income to expect and how much more to save on their own. Just imagine the dif f erence between retiring in 2007 versus 2009. It is f urther true that even if investments work out as hoped f or, the new Def ined Contribution pension plans being of f ered by Air Canada and Canada Post should not be expected to result in benef its as large as the Def ined Benef it plans they want to close. For the level of benef its now promised to Air Canada and Canada Post workers, employer contributions in excess of 10% of pay would be expected in todays climate. One would not anticipate the new Def ined Contribution plans being that rich. So, the benef its being negotiated are important and real. Management will continue to attempt to pass the pension risks over to the workers by using Def ined Contribution plans and workers will work equally hard to retain their Def ined Benef its. T hats the reason f or all the f uss. Rob Brown was Professor of Actuarial Science at the University of Waterloo for 39 years and a past President of the Canadian Institute of Actuaries. He is currently an expert advisor with EvidenceNetwork.ca, a comprehensive and non-partisan online resource designed to help journalists covering health policy issues in Canada.